Heartland Mid Cap Value Fund 4Q18 Portfolio Manager Commentary

Executive Summary

Stock selection was strong on a relative basis in a number of areas as the Fund beat its passive Russell Midcap® Value benchmark returning -13.41% versus -14.95%.

A focus on potential economic pitfalls led investors to reevaluate their appetite for risk.

Selling pressure has led to an increase in high-quality, attractively valued names hitting our watch list.

A disciplined application of our process we believe will be key to navigating the quarters ahead.

Fourth Quarter Market Discussion

Headwinds that had been gathering in the distance since mid-year took on greater urgency during the period. Among the concerns investors grappled with were escalating trade tensions, rising interest rates, and the challenge companies face to maintain already lofty growth rates.

The focus on potential pitfalls led investors to reevaluate their appetite for risk. The result was a jump in volatility, a move toward more defensive areas of the market and a heightened focus on valuations, as shown.

Growth Losing its Luster?

Russell 3000® Value/Russell 3000® Growth Index

Source: Bloomberg L.P. and Russell®, 10/1/2018 to 12/31/2018
Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.
All indices are unmanaged. It is not possible to invest directly in an index.Past performance does not guarantee future results.

The cautious approach led to broad selling but also set the stage for a more attractive opportunity set for active investors.

Attribution Analysis

Stock selection was strong on a relative basis in a number of areas as the portfolio beat its passive Russell Midcap® Value benchmark for the quarter and full year. Financials stood out on a relative basis, along with the strategy’s Information Technology holdings. The portfolio’s Health Care names lagged.

Gaining altitude. The general tone for Industrials companies was weak but opportunities remained and the group contained a top contributor. Shares of Spirit Airlines, Inc. (SAVE) were up after management reported solid earnings and issued better-than-expected guidance.

In the past year, the discount airline faced pressure as larger carriers slashed prices and raised capacity in pursuit of market share in major hubs such as Chicago. Our take has been that excess capacity is a temporary challenge that would subside as fuel prices increased—and that Spirit’s low-cost advantage would allow it to weather heightened competition. Recent months have borne out this view, as the influx of capacity has ebbed and airlines have benefited from a strong economy and confident consumers. Spirit has also improved its competitiveness by improving its on-time flight performance and offering amenities such as inflight Wi-Fi.

The airline has a long runway in terms of expanding into additional markets, and we think its mix of clients, which is light on business passengers, will help it hold up should corporate spending soften.

A popular choice. The portfolio’s Financials names were down on an absolute basis but fared much better than those in the benchmark. Solid performance came from several industries in the sector, but not all names advanced. Shares of Popular, Inc. (BPOP), the largest bank in Puerto Rico, were off despite signs that economic conditions in the U.S. commonwealth were on the mend following last year’s devastating Hurricane Maria.

Loan losses for the bank have been lower than expected following the storm, and stimulus funds aimed at reinvigorating the island’s economy are expected to also benefit the local banking industry. Management’s conservative approach to lending has provided it with significant excess capital liquidity. We believe those funds will be used to continue to pay dividends, buy back shares, or put to work through opportunistic deals that we believe could benefit long-term results. Earlier this year, the bank bought a book of local auto loans from one of its mainland-based competitors. The acquisition was completed at very favorable terms and has been accretive to earnings.

Despite Popular gaining traction in its market, shares still trade at just 1.1X tangible book value. Mainland banks with comparable return on equity typically trade at a tangible book multiple that is 50% to 100% higher. The premium is noteworthy because the bank faces the same regulations and is part of the safety and soundness of the U.S. system.

Good communicator. Communications Services was another bright spot for the strategy with holding Omnicom Group Inc. (OMC) up in a sector that was down for the period. The global advertising agency benefited from an uptick in organic sales growth driven by strength in the European Union and the Asia-Pacific region. We were pleased with the results and hope to see sales improvement in the U.S. in the quarters to come.

Under the weather. Health Care names in the benchmark and portfolio struggled this quarter and the sector contained a key detractor for the strategy. Long-time holding Quest Diagnostics, Inc. (DGX), a diagnostic testing and services company trading at 14x estimated 2018 earnings, was down after issuing lower-than-expected guidance for the fourth quarter. Management sought to temper expectations after seeing a jump in the number of billing claims rejected by insurers. The company believes the contested charges are an isolated incident and is working to recoup at least a portion of the outstanding balances owed.

The poor recent results have, in our view, masked what is a great long-term story. Quest should benefit from regaining its status as an “in-network provider” with UnitedHealth Group (UNH). The designation should help Quest as it seeks to capture business from United’s large book of insured population.

Quest should also benefit by growing its hospital outreach business as hospitals either outsource lab operations or look to team with a third-party to help them run the business. The company is a low-cost provider of diagnostic testing services—with competitors often 2x to 5x more expensive—which we believe provides a competitive advantage over peers.

The stock remains attractively valued in our view, and we believe that growth and cost-reduction initiatives are now accelerating.

Portfolio Activity

Selling pressure spurred by economic concerns has led to an increase in high-quality, attractively valued names hitting our watch list. We continue to scour both economically sensitive and defensive areas for opportunities but are following our fundamental analysis to where it leads. We have added some high-quality names such as Thor Industries, Inc. (THO), the largest recreational vehicle (RV) manufacturer in the world. The company owns iconic brands including Airstream, Dutchmen, Jayco and Keystone among others.

The RV market has enjoyed a strong run following the financial crisis but stumbled going into the 2018 selling season as aggressive pre-ordering by dealers was met with sluggish retail demand. The resulting excess inventory has put pressure on margins and investors have punished industry players. However, we believe Thor is making meaningful progress on reducing dealer inventory, and the company is on the cusp of closing on the acquisition of a large European operator in the coming months. Company management has a proven track record of prudent acquisitions and we believe this transaction could add 25%-30% to earnings per share over several years.

With the company trading at less than 7x our view of normalized earnings compared to a historical average of 13.5x, we believe the current slump in share price offers a compelling opportunity to own a market-leading player with meaningful upside potential in the years ahead.

Outlook and Positioning

As bottom-up investors, we believe our job is to seek attractively valued companies that are well positioned to improve results and gain traction with investors. As such, we avoid making market calls and instead focus on capitalizing on the opportunities presented. The current environment, while painful, has created a pool of opportunity that is well-stocked with high-quality companies trading at compelling multiples.

As we sort through the companies that hit our radar, we will continue to adhere to our philosophy and process. The team continues to focus on valuations, balance sheet strength and catalysts that can result in a change in perception by investors. We believe this disciplined application of our process will be key to navigating the quarters ahead.

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Portfolio Management Team

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 16 years of industry experience, 9 at Heartland.

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 18 years of industry experience, 15 at Heartland.

In the prospectus (pdf) dated 5/1/2018, the Net Fund Operating Expenses for the investor and institutional classes of the Mid Cap Value Fund are 1.25% and 0.99%, respectively. The Advisor has contractually agreed to waive its management fees and/or reimburse expenses of the Fund to ensure that Net Fund Operating Expenses for the Fund do not exceed 1.25% of the Fund’s average net assets for the investor class shares and 0.99% for the institutional class shares, through at least 5/1/2019, and subject thereafter to annual reapproval of the agreement by the Board of Directors. Without such waiver and/or reimbursements, the Gross Fund Operating Expenses would be 2.50% for the investor class shares and 2.45% for the institutional class shares.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance information for institutional class shares of Funds that existed prior to their initial public offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

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Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

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The Mid Cap Value Fund invests in a smaller number of stocks (generally 30 to 60) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns. The Fund also invests in mid–sized companies on a value basis. Mid-sized securities generally are more volatile and less liquid than those of larger companies. There can be no assurance that the Fund will grow to or maintain an economically viable size, in which case the Board of Directors may determine to liquidate the Fund.

There is no assurance that dividend-paying stocks will mitigate volatility.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.